Factors Which Influenced the 2007-2008 Financial Crisis

Corporate Financial Management
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CORPORATE FINANCIAL MANAGEMENT
Corporate financial management entails the use of financial principles and concepts within a corporation or company in order to generate and sustain financial worth through appropriate resource management and effective decision-making (Arnold, 2008, pp 3). Hereby, plans and strategies are developed and investment decisions are made for the financial benefit of the corporation. This involves goal-setting and strategic planning how to accomplish the goals and how to pay for them. Financial management is a crucial aspect which sustains companies and even nations. This is so as it is only through sustainable financial positions and viability that companies and even nations are able to operate and run.
Financial management helps avoid a financial crisis, which can be at different levels. The financial crisis of 2007/8 was a crisis with extensively devastating impacts; it was considered the worst financial crisis of the twenty-first century. It was thus termed as the global financial crisis. Northern Rock PLC was the bellwether bank, which suffered during this financial crisis of 2007-2008. Accordingly, the paper will look at the Northern Rock Plc as a case study. It will explain the factors which influenced the aforementioned financial crisis. It will further delineate how these factors impacted on Northern Rock Plc and the reasons as to why the company was nationalized. In addition, it will evaluate the net outcomes of the nationalization. The paper will also assess the measures to prevent repeated financial crises in the future. Finally, the paper will present a viewpoint on whether the trigger for the financial crisis has been resolved and whether Northern Rock’s rescue was a positive or negative thing.
Factors Which Influenced the 2007-2008 Financial Crisis
The financial crisis of 2007/8 was the worst financial disaster since the Great Depression of 1929(Amadeo, 2018, pp 15). This 2007/8 financial crisis led to the Great Recession. The initial indications of this began in 2006 when the housing prices began to drastically fall (Amadeo, 2018 pp 21). This led to the subprime mortgage crisis caused by banks selling excess mortgages to meet the demand for mortgage-backed securities. The price of houses began drastically dropping in 2006. By 2007, the home ownership rate was at an alarming record of 68.6 percent (Chari, Christiano & Kehoe, 2008). The housing price declines led to defaults. This risk trickled into the mutual funds and pension fund. This posed a great risk for the corporations which owned the derivatives. This triggered the 2007 banking crisis, hence the 2007-2008 financial crisis (Amadeo, 2018, pp 6).However, many assumed at the beginning that the declines would never be national and/or simultaneous.
Figure SEQ Figure \* ARABIC 1: The Housing Pricing
Banks simply play the mediator role between the sellers who are the depositors and the loan takers who are the buyers. The banks give the sellers an interest rate by charging an even higher one on the buyers. This gives them their profit. When banks fail to have short-term funding their liquidity is highly threatened hence the banks are unable to repay their depositors. Lo (2012, p 160) indicates that there are different factors that influenced the 2007/8 financial crisis and no consensus has been reached on the exact causes. Thakor (2015, p 178) insists that the crisis was the climax of the 2006 credit crunch that proceeded in 2007.
Banks use the technique of securitization whereby they sell many of their loans to large financial companies termed as securitizers. The pooled securities are used to back debt obligations. The securitizers pool the loans and use the pools of loans in securities that traded in financial markets. The owners are entitled to a share of the payments from the securities. The issuers of the securities often keep the residual risks termed as tranching of the loan pools. Home mortgages are common loan market items to be securitized. Mortgage-backed securities were issued famously by Fannie Mae and Freddie Mac. In the early 2000s, Fannie Mae and Freddie Mac change from buying only prime mortgages to purchasing even subprime mortgages backed primarily by the prime mortgages (Bigio & La’o, 2011, p 7).
Investment banks saw more opportunities in the subprime mortgages. Hence, more banks securitized the subprime mortgages to gain a larger share of the securities. Bigio and La’o (2011, p 7) postulate that this thriving system of securitization was plagued by greedy realtors and bankers. More than 84 percent of the 2006 subprime mortgages were issued by private lenders (Denning, 2011, pp 1). This prompted the financial crisis coupled up with an issue of systematic mispricing. The subprime lending and the securitization gave room for a correlation that made the financial system vulnerable to shocks (Bigioa & Lao, 2011, p 7). These shocks bore huge losses for the residual risk bearers. In early 2007, there was a home sales peak period up until around September 2007. Single-family home resales lowered by 25 percent to four point three eight million in that year (Amadeo, 2018, pp 1). The housing market deteriorated but people did not realize how bad it was.
Prior to this, The United States government had experienced a short-lived recession in 2001 which the economy was able to withstand. The Federal Reserve Board, as a counter action, lowered the federal fund rates from six point five percent in May 2000 to one point seven five percent in December 2001(Claessens & Kodres, 2014, p 5). This enabled investors to be interested in higher yielding subprime mortgages. Interest rates were dramatically slashed by the government to even an all-time low of one percent in June 2003(Claessens & Kodres, 2014, p 5). Hence, there was a rapid asset price appreciation, especially with the housing sector. The problems began when the interest rates began to increase and home ownership came to a satiation level. Banks started holding their derivatives to increase their profits.
Fraudulent activities also fuelled the financial crises. This was evident during this financial crisis period whereby firms securitized and sold toxic mortgage-backed securities to other institutional investors. In 2005, there was a yield curve invert (Amadeo, 2018, pp 1).The interest rates kept increasing to five point two five percent in June 2006 on until August 2007(Amadeo, 2018, pp 1). This led to drastic fall in housing prices. Many suboptimal borrowers defaulted their loans owing to the increasing interest rates. Many subprime lenders filed for bankruptcy. Also, the salvage of Bear Stearns by the Federal Reserve through JP Morgan Chase loaning it thirty billion dollars triggering the Lehman Brother’s bankruptcy.
Earlier in 2007, some economists had tried to warn again a possible recession. These were ignored just as history was clearly ignored in terms of financial regulation. However, in March 2007, the stock markets rebounded giving hope for financial viability. These problems trickled beyond United States borders. China’s Shanghai index dropped leading to global panic from investors. The housing slump spread to the financial industry. The hedge fund sector, which is unregulated had invested massively in the mortgage-backed securities. Amadeo (2018, pp 1) elucidates the concept of derivatives as financial contracts which derive their worth from underlying assets. Hedge funds use complex derivatives meaning extensive adverse effects on them. The shadow banks which are not regulated by the Federal Reserve contributed to the financial crisis. In addition, 2007 saw a decline in the durable goods orders by two percent (Amadeo, 2018, pp 1). This was a clear indication that businesses were holding off buying goods as they lacked confidence in the economy.
Amadeo(2018, pp 1) stipulates that the housing slump thus the financial crisis was enabled by the  Gramm-Rudman Act which enabled banks to take part in trading profitable derivatives to sell to investors. Hera (2010, pp 20) sums up the root cause of the financial crisis as tied to over the counter derivatives. Ruffini and Steigerwald (2014, p.85) explains over the counter derivatives as privately negotiated and traded contracts which are traded between two parties without any intermediaries or passing through an exchange. In the 2007/8 financial crisis, these over-the-counter derivatives allowed concentration of large counterparty exposures between market participants which were not properly risk-managed.
Counterparty risks were heightened by rising credit risk proclaimed to end owing to the concept of credit default swaps. Credit rating agencies such as Moody’s also influenced the financial crisis as they leniently assessed the banks (Claessens & Kodres, 2014, p 5). Hence, investors invested in the securitized products as they deemed them safe. The house pricing fall and the decline of the subprime mortgage pricing adversely affected financial markets (Allen & Carletti, 2010, pp 3). The crisis caused the interbank market to completely freeze. Verick, S., and Islam (2010, p.3) posit that the severity of the worldwide downturn has been underestimated Many banks were affected such as the Northern Rock bank which had to seek different ave...